Saturday, December 10, 2011

How to save tax (under section 80C)

This particular blog is for students who passed out of college in 2011 and are working for the first time – here, I would like to share the various tax saving options that you have and my recommendations as to how you can minimize your tax outflow.

You can invest up to Rs 1 lac and save on taxes under section 80C of the Income tax act. The amount invested under section 80c is directly deductible from your gross annual income for tax calculation purposes – what this means is that if your gross annual income is Rs 5 lacs and you invest Rs 1 lac under section 80c, your taxable salary goes down to Rs 4 lacs (on which you will need to pay the tax).

Now what are the various avenues for investment under section 80c?

The first avenue is Provident fund (PF). You already would be investing in PF through statutory deductions from your salary – your contribution to PF is tax deductible section 80c. Beyond this statutory PF deduction, you can also invest additional amounts in PF through voluntary PF (VPF) by instructing your payroll team to deduct additional amounts every month - this too is tax deductible under section 80c.  Currently PF investment gives you a return of  8.5% per annum. As you may know, PF accumulates throughout the working life and you get a lump sum once you retire. As you move from one company to another company, you move your PF money as well.

The second option that you have is the Public Provident fund (PPF) –for this you will need to open a PPF account in a bank (most banks offer PPF facility) – PPF currently gives you returns of 8.6% and this is tax free- the minimum you need to put is Rs 500 and the maximum amount you can invest is Rs 70,000 per annum. The PPF account has a term of 15 years and you need to invest for 15 years before you can close it and take the money out (there are ways to take money as loan before).

The third option that you have is Life insurance premiums and ULIP’s.  You can go through not just LIC - but any private insurer for this. I have always recommended that the only Life insurance that you must take is pure term insurance – any other life insurance policy (like endowments, ULIP’s, annuity /pension plans etc) are sub optimal investments with returns of around 6-7% over a long period.  I believe that insurance is mis-sold as an investment / tax saving avenue in India and we must only look at insurance as a risk mitigation tool. So insurance is not recommended for tax saving .

The fourth option that you have is Equity linked savings schemes ( ELSS) offered by mutual fund companies – these schemes have a lock in of three years. Data in moneycontrol.com tells me that the top ELSS schemes in India as per Crisil rating are Franklin India tax shield, Religare tax plan and Fidelity tax advantage – these schemes have given a return of appx minus 10% to -14% for one year, +4 to 5% annualized returns for two years and +25 to 27% annualized returns for three years. As equity investments are to be looked at for 3 years and above, these schemes have given good returns in that time frame. But as we all know, good past performance does not ensure good future performance.

The fifth option is five year bank or post office deposits – these are also covered under section 80c. The returns here are 7.5% to 8%.
Then there are rural electrification bonds and infrastructure bonds where you have a 3-5 year lock in –the interest earned in these schemes is appx 5-6% ( post tax).
There are other ways of investing under section 80c, that may not make sense to my students – for example, if you have a housing loan, then you can repay the principle and that would be deductible from taxable income under section 80c. Also, payment of tuition fees for upto two children in any Indian school, college or University would be deductible from taxable income under section 80c.

Having seen the most common options available,  for someone below 30 years of age and earning about 4-10 lacs  – I would recommend ELSS schemes or PPF beyond the PF that you are already investing.

The last issue that I want to address is the timing of these investments – we are now in December and we are deciding on these investments for the year 2011-12. This timing is sub optimal. We all know that the earlier we invest, the earlier the returns start accumulating and hence, I would recommend that for next year ( 2012-13) - you decide and invest as early as possible –  in April or May - or surely by June.